Another Victory for the Laffer Curve, this Time over the Lifestyle Puritans

Well, they both start with the same letter, so maybe the Cookie Monster could incorporate them into his favorite song, but I’m thinking about something else. Specifically, both cigarettes and capital gains tell us something important about tax policy, the Laffer Curve, and the limits of political bullying.

In both cases, there are folks on the left who disapprove of these two “c” words and want to penalize them with high tax rates.

But it turns out that both cigarettes and capital gains are moving targets, so the politicians are grossly mistaken if they think that punitive taxation will generate a windfall of revenue.

I’ve already discussed why it’s senseless to impose high tax rates on capital gains. Simply stated, people can avoid the tax by not selling assets.

This might not be an ideal way of managing one’s investments, and it certainly isn’t good for the economy if it discourages new investment and prevents people from shifting existing investments into more productive uses, but it’s very effective as a strategy for individuals to protect against excessive taxation.

We see something quite similar with cigarettes. People can simply choose to buy fewer smokes.

Michel Kelly-Gagnon of Canada’s Montreal Economic Institute explains why higher tobacco taxes are not a guaranteed source of revenue for the political class.

Tax increases do not in each and every case lead to increases in government revenues. …When taxes on the consumption of a good are too high, you can get to a point where taxable consumption decreases and government revenues diminish rather than increase. Or at any rate, they don’t increase as much as what would be expected given the tax increase. This phenomenon constrains government’s ability to levy taxes. …There have been numerous examples in Canada of excessive taxes having a negative impact on government revenues. As shown by my colleagues Jean-François Minardi and Francis Pouliotin a study published last January., there’s been three “Laffer moments” when it comes to tobacco tax revenues in Quebec since 1976. Whenever the level of taxation exceeded $15 per carton, the proceeds of the tobacco taxes eventually diminished. These are no isolated incidents. Laffer shows that the theory is confirmed by the experience of Cyprus, Denmark, Germany, Great Britain, Greece, Ireland, Latvia, Portugal, and Sweden.

Here’s a chart from his column showing how tax revenue has dropped in Quebec when the tax burden became too onerous.

Michel then acknowledges that some people will be happy about falling revenue because it presumably means fewer smokers.

But that’s not necessarily true.

While it is true that some people are deterred from smoking by tax increases, this is not the case of all smokers. Some avoid taxes by buying contraband cigarettes. Tax increases have no effect on the health of these smokers.

And because the tax burden is so severe, the underground economy for cigarettes is booming.

Since2008, Mackinac Center for Public Policy analysts have periodically published estimates of cigarette smuggling in 47 of the 48 contiguous states. The numbers are quite shocking. In2012, more than 27 percent of all Michigan in-state consumption was smuggled. In New York, almost 57 percent of all cigarettes consumed in the state were also illicit. This has profound effects on the revenue generated by state (and sometimes local) government. …We estimate nationwide revenue losses due to cigarette smuggling at $5.5 billion, a statistic consistent with the Bureau of Alcohol, Tobacco, Firearms and Explosives’ $5 billion estimatefor 2009.

P.P.S. Art implies, at least indirectly, that policy makers should set the tax rate on tobacco at the revenue-maximizing level. That is far better than having the rate above the revenue-maximizing level, to be sure, but it rubs me the wrong way. I will repeat to my final day on earth that the growth-maximizing tax rate is far superior to the revenue-maximizing tax rate.

P.P.P.S. I’m currently in Australia for a series of speeches on fiscal policy. But as you can see from this photo, the PotL and I managed to find time to act like shameless tourists.

P.P.P.P.S. Since I’m imitating Crocodile Dundee in the photo, I should close by noting that Paul Hogan (the actor who played Crocodile Dundee) has been harassed by the Australian tax police.

10 Responses

A Laffer Curve provides only a static analysis. The Laffer maximum revenue point is where the increase in revenue from the increased tax rate is exactly equal to the reduction in the size of the tax base, at a single point in time.

Obviously, the next time the analysis is done you will be dealing with a smaller tax base. And, you may be dealing with a different curve. For example, if Canada or other competitors were to cut corporate tax rates, it would affect decisions as to the impact of higher possible US tax rates.

Since the growth-maximizing tax rate will grow the economy faster, a dynamic view of tax revenue should move toward that rate.

However, a real world view of maximizing government revenue (I’m not in favor of this, so this is to inform those that want to maximize revenue), should consider the time value of lost tax revenues, at government’s borrowing cost. Since the growth-maximizing rate will bring in less revenue than the revenue maximizing rate, in the early stages.

Therefore, maximizing future government tax revenues [minus the cost of borrowing] will require that the tax rate be set somewhere between the growth-maximizing tax rate and the static revenue maximizing rate.

At some price point many more people will start growing their own tobacco, which seems to be legal — for the time being, but don’t hold you breath it will stay that way. So as we move towards decriminalizing marihuana, we are criminalizing tobacco. The dance of coercive collectivism. Keeps voter-lemmings happy drinking the cool-aid of community activism, ever more busy with politics — and keeps politicians employed, wealthy and powerful.

Meanwhile, in the real economy, a growth trendline of 2% is steadily and relentlessly compounding American middle class standard of living towards the true middle class: the world average. I guess what we need is another civil war of intellectual energy diversion as we fight for what will prevail, what will be banned, taxed, subsidized? Marijuana? Nicotine loading? Caffeine loading at Starbucks? Fair trade peyote? Tune in to your local channel voter-lemmings, for the great people’s legislative extravaganza. Make your lists with what you disapprove of and fight to have it banned in the big colosseum of coercive collectivism. A 2% growth deficit compared to the world average? Aaa.. It’s for the next generation to worry about…

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As has been pointed out a few times, the Laffer curve is not static. There is a different Laffer curve for different time horizons. As the time horizon lengthens, the Laffer curve compresses and its maximizing point shifts earlier and earlier, ie at a lower tax rate. This is simply because longer term horizons start incorporating longer term decisions, including people’s lifetime productivity trajectories, and also the effect of different growth rates which after a few years start compounding.

As the time horizon increases, the Laffer Curve assumes the exact shape of the Rahn curve. This is because, in the long term, compounding growth, or lack thereof, becomes the dominant factor in tax revenue — and by the way, prosperity too.

Please, I’m too busy to write a paper on it, but someone who knows the economics jargon better could probably write a nice paper: “As the time horizon increases the Laffer curve asymptotically converges to the Rahn curve”.

But there is also another concept of hypocrisy, or perhaps just cognitive dissonance in this story.

These days, the anti-smoking campaign is mostly waged by the left (or, more generally progressives), who having great propensity towards coercive collectivism want to impose the one size fits all progressive citizen. Body piercings are diversity, but hijabs are oppression, even when done voluntarily.

So presumably, these are leftist people who, unlike selfish capitalists, care about their fellow humans and are willing to impose (and presumably subject themselves) to “modest” sacrifice to serve their fellow humans, like 50% tax rates. But, horror of horrors, don’t you dare blow 0.1mg of smoke a year in their direction!

Hence smoking at any distance closer to 300ft from any liberal (progressive in general) has to be banned. Because these people care so much about their fellow citizens, respect so much diversity that they cannot bear the externality of breathing in 10 molecules of smoke from someone puffing 100 ft. away, or cannot bear the fact that 5-10% of restaurants may actually allow smoking if permitted to do so. That is the true altruism, compassion and tolerance of coercive collectivism: Liberty for me (mostly to take other people’s wallets) but not for thee. It is 20% altruism and 80% self-interest.

But it’s suicidal because it leads to a 1-2% Euro-growth trend line to a compounding decline.

[…] and provide cigarettes in the black market. We saw this in Bulgaria and Romania. We saw in in Quebec and Michigan. And we saw it in Ireland and Washington, DC. As I explained a couple of years ago, “In many […]